Friday, February 27, 2015

A pronounced cyclical Eurozone upswing is in the offing

The structural factors holding back
the Eurozone remain substantial, most notably poor demographics, high
indebtedness and a lack of reforms in large countries such as France and to a
lesser extent Italy. These structural deficiencies are mainly responsible for relatively
low trend growth, probably close to around 1.5%. On the other side, cyclical
forces are about to provide the strongest aggregate growth support in a long
time. As a result, Eurozone growth should increase markedly in the quarters
ahead, likely moving to around 2.5% on an annualised basis by year-end.

First, oil prices in Euro have
collapsed and are now down by approx. a third since June last year. It is thought
that a 10% drop in oil prices reduces the CPI index by approx. 0.2% and might
increase GDP by 0.3%. However, the effects on inflation have largely run their
course after three months while it takes 3-4 quarters before the effects on
growth become visible. Hence, oil prices are only just about to start exerting
their growth positive impetus with the support becoming ever stronger as the
year progresses.

Second, the Euro has appreciated
since the summer of 2012 until reaching a high in between Dec13 and March14
before moving slightly lower during summer and sharply lower from December
onwards. Changes in the trade-weighted currency usually take around 6-9 months
before they are being reflected in the economy. Hence, so far only the growth
negative effects of the previous strong Euro period should have been absorbed.
The growth positive effects of the subsequent Euro weakening are just about to
begin and should also become stronger as the year progresses.

The collapse of oil prices (in Euro,
red) and the fall in the trade-weighted Euro (white) will exert a growth
positive effect

Source: Bloomberg

Third, real yields have moved sharply
lower. 10y German real yields have already from 2009 started to become growth
supportive as they fell from 2% in 2008 to below 1% in 2011 and have traded
below 0% for most of the time since 2012. On the other side, peripheral real
yields have been at historically high levels during recent years, thereby
exerting a growth negative effect on the economy. As an example, 10y BTP real
yields increased from approx. 2.5% in 2008 to 7% in late 2011, before starting
to fall as the ECB implemented its emergency measures. Still, even at the beginning
of last year, 10y Italian real yields hovered around 3%, a substantially
restrictive level for a country where trend growth stands around 0.5%. By now,
though, real yields have fallen to approx. 0.3% and should thus provide for an
increasing growth tailwind.

10y BTP real
yields (left) have become growth supportive

Source:
Bloomberg

Fourth, credit creation has been
negative ever since the Eurozone sovereign crisis broke out in 2011. The right-hand
chart below shows the yoy growth rate of MFI loans to the private sector. Loan
growth peaked in 2011 when the Eurozone debt crisis broke out and moved into
negative territory. Negative loan growth became even more pronounced during
2013 as banks prepared for the ECB’s comprehensive assessment (as the end 2013
balance sheets were used for the AQR). However, loan growth has bottomed a year
ago and has slowly recovered since. The outstanding level of loans has bottomed
in August last year, just ahead of the release of the AQR results. In between
September 2011 and August 2014, loans were reduced by a total of EUR 670bn, which
also constituted a significant drag on the economy. Looking ahead, though, the
banking sector has been largely recapitalised and the new single supervisory
mechanism (SSM) is now in place. Banks are thus finally in a position to more
actively manage their balance sheets while improving growth coupled with lower
loan rates – substantially so in the periphery – suggests that loan demand
should pick up again. Hence, credit creation promises to move back into
positive territory, thereby also turning from a growth headwind to a tailwind.

Credit creation has
bottomed

Source:
Bloomberg

As a result, monetary policy has
finally become accommodative for the periphery for the first time since the
Eurozone debt crisis broke out in 2011. Moreover, fiscal policy has been a significant
drag on growth in recent years amid large scale austerity measures. According
to the IMF, the cyclically adjusted primary balance for the Eurozone has moved
from a deficit of 2.5% in 2010 to a surplus of 1.2% in 2014. Hence, fiscal
policy has accounted for a drag of approx. 4% of GDP or 1% per year in recent
years. However, the austerity drive has weakened during recent quarters and
fiscal policy has moved from being very restrictive to becoming only mildly so
and thus the growth negative impact should be much smaller as well.

On a country basis, Germany should
continue to do well amid growing exports and a supportive backdrop for the
domestic economy (low real yields, high employment, rising real wages). More
importantly, France and Italy promise to move from below trend to above trend
growth by the end of next year. The substantially weaker Euro should be of
vital importance for these countries exporters given that they mainly compete
via price and less via product complexity/quality such as for example Germany.
In the case of Italy, the sharp drop in nominal and real yields should also
provide for relatively higher support.

Summing up, monetary policy as well
as oil price and exchange rate developments turn from a significant growth
negative factor towards a marked growth positive one while the growth negative
impetus of fiscal policy abates. Therefore, Eurozone growth should move from a below
trend pace to a markedly above trend one of around 2.5% on an annualised basis
towards year-end. As growth improves, so should the long-run trajectories for
the debt-GDP ratios across the Eurozone. The structural primary balances have
mostly moved into surplus already and fiscal deficits should become
significantly lower amid higher growth and lower yields. Markets should
increasingly focus on these materially improving Eurozone growth prospects.

1 comment:

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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